S mall business retirement plans typically fall into one of three categories: Individual Retirement Accounts (IRAs), defined contribution plans [such as 401(k)s], or defined benefit plans. Within these categories, several options exist, enabling small business owners to select the best plan for their needs. This article explores 10 retirement plans a small business owner might use. We explain what each plan is and discuss several pros and cons. Before we get into plan specifics, however, let’s address some retirement plan basics.
Retirement Plan Commonalities
As the most common small business retirement plans, IRAs and 401(k)s enable employees and employers to invest funds for retirement. Those retirement accounts can grow or shrink based on performance. Employees do not contribute directly but may defer portions of their compensation to contribute indirectly. Once employees reach a certain age or retire, they begin withdrawing or receiving distributions.Defined benefit plans work differently. The employer contributes a specific amount, and the employee receives a set amount upon retirement rather than an amount that depends on investment returns and varies by yearly contribution.
IRAs
Certain facts apply to most IRA plans, including:
Setup—create a written agreement describing the benefit plan, provide information about the plan to your employees, and set up an account for each employee.
Contribution limits—contribute the lower of up to 25% of an employee’s compensation or $69,000 (as of 2024).
Withdrawal rules—if employees withdraw funds before age 59.5, the withdrawal is subject to income tax and an additional 10% tax.
Tax Benefits—employers can deduct contributions within the appropriate limits.
We address the differences between three IRA-based plans below.
Defined Contribution Plans: 401(k)s
Commonalities between different 401(k) plans include:
Setup—employer adopts a written plan, arranges a trust in which to place trust assets, establishes a recordkeeping system, and provides employees with a Summary Plan Description (SPD) to enable them to participate.
Contribution limits—as of 2024, employers may contribute up to the lesser of 100% of employee compensation or $69,000.
Filing requirements—employers must file Form 5500 with the Internal Revenue Service (IRS) annually and regularly make participant disclosures.
Distribution rules—the IRS may charge an additional 10% tax on tax distributions made before age 59.5 unless an exception applies.
Plan restrictions—employers cannot require employees to complete more than one year of work before qualifying to participate.
Tax benefits—employers can deduct contributions (within contribution limits), and tax is deferred on compensation deferrals and gains on investments until distribution.
We detail six defined contribution plans below.
1. Simplified Employee Pension (SEP) IRA Plan
Simplified Employee Pension (SEP) plans work as follows:
Contributors—only employers contribute to these plans.
Contribution rules—employers must contribute an equal percentage to all employees, up to 25% of the employee’s pay.
Vesting period—vesting is immediate.
Options—employers cannot offer other options for an employee’s retirement plan.
SEP plans tend to work well for small businesses and those that are just starting.
2. Savings Incentive Match Plan for Employees (SIMPLE) IRA Plan
Savings Incentive Match Plan for Employees (SIMPLE) IRA plans work as follows:
Contributors—employers are obligated to contribute, and employees have the option of contributing if they choose to.
Contribution rules—employers must either match up to 3% of the employee’s contribution or 2% of the employee’s compensation.
Special business qualifications—plans are typically limited to businesses with 100 or fewer employees.
Vesting period—vesting is immediate.
Options—no additional plans are permitted.
Special rules—if employees withdraw funds within two years of beginning participation, the 10% tax increases to a 25% tax.
SIMPLE plans are similar to SEP plans. The main differences between SEP and SIMPLE IRAs are the employer contribution requirements, the two-year withdrawal tax increase, and the limitation on the size of the business in the SIMPLE IRA.
3. Payroll Deduction IRA
In a Payroll Deduction IRA, the employer deducts a portion of the employee’s compensation on their behalf through the payroll process. Other terms of Payroll Deduction IRAs include:
Contributors—only employees contribute.
Contribution rules—employer deducts after-tax contributions from the employee’s paycheck and transmits them to the employee’s chosen institution.
Vesting—vesting is immediate.
Options—additional plans are permitted.
Payroll Deduction IRAs offer a simplified process and low upkeep.
4. Defined Benefit Plans
In defined benefit plans, the employer selects a formula that determines a fixed amount to provide to employees at retirement—commonly called a pension. These plans include the following details:
Contributors—employers must contribute, but some plans obligate employees to contribute and some do not.
Contribution rules—these vary by plan.
Filing requirements—employers must annually file Form 5500 with the Internal Revenue Service (IRS), and an enrolled actuary must sign Schedule SB.
Vesting—vesting may be immediate or may take up to seven years.
Distributions—plans typically cannot make distributions before age 59.5.
Plan Restrictions—the IRS may impose excise taxes if contributors do not satisfy the minimum contribution amount or make excess contributions.
Options—additional plans are permitted.
These plans can vary significantly, allowing you to tailor them to your business’s needs.
5. Traditional 401(k) Plans
Traditional 401(k) plans have the following characteristics:
Contributors—employees contribute through salary deferrals, and employers also contribute.
Contribution rules—employees may defer portions of their compensation, and employers may match these contributions, contribute only to employees who opt to defer, or contribute to all participants.
Vesting—vesting may be immediate or may take several months or years; and
Options—additional plans are permitted.
Traditional 401(k)s offer flexibility and allow employers to tailor contributions more.
Small business retirement plans typically fall into one of three categories: Individual Retirement Accounts (IRAs), defined contribution plans [such as 401(k)s], or defined benefit plans.
6. Safe Harbor 401(k) Plans
Rules specific to Safe Harbor 401(k)s include:
Contributors—employers contribute, and employees contribute through salary deferrals.
Contribution Rules—employers may contribute by matching employee deferrals or may opt to contribute only to employees who defer or to all participants regardless of deferral.
Vesting—vesting is immediate.
Options—additional plans are permitted.
Safe harbor plans get their name because the vesting process occurs immediately.
7. SIMPLE 401(k) Plans
SIMPLE 401(k) plans work as follows:
Contributors—only employers are obligated to contribute.
Contribution rules—employers must either match employee’s contributions up to 3% of their compensation or contribute 2% of employee compensation.
Special deferral rules—as of 2024, employees may defer up to $16,000 of their compensation.
Special business qualifications—plans are typically limited to businesses with 100 or fewer employees.
Vesting—there is immediate vesting of salary deferral, and employer contributions may vest immediately or after a period of months or years.
Options—additional plans are not permitted.
SIMPLE 401(k) plans and SIMPLE IRAs rely on the same core requirements.
8. Profit-Sharing 401(k) Plans
Profit-sharing plans involve:
Special setup rules—the employer selects a formula to allocate contributions.
Contributors—employer only (discretionary) may contribute.
Contribution rules—the business uses discretion to decide when and whether to contribute to separate employee accounts.
Vesting—vesting may begin immediately or after up to six years.
Options—other plans may be offered.
Profit-sharing 401(k) plans enable employers to make discretionary contributions regardless of whether the business makes a profit.
9. Money Purchase 401(k) Plans
Money purchase plans involve an employer selecting a percentage of an employee’s compensation to regularly contribute, regardless of how the business performs. The following rules apply:
Contributors—employers only (obligatory) contribute.
Contribution rules—the employer must contribute its selected percentage to each participant each year.
Vesting—vesting is immediate.
Options—additional plans are permitted.
Despite the name, employees do not buy money purchase plans.
10. Automatic Enrollment 401(k) Plans
Employers may opt for a 401(k) plan that, instead of having an opt-in option, requires employees to opt out. These automatic enrollment plans involve:
Contributors—employees (salary deferral) and employers (optional) can contribute.
Contribution rules—the employer automatically reduces the employee’s compensation by a fixed percentage and contributes that amount to the 401(k) plan; however, the employee may opt out of the automatic reduction or select a different percentage.
Vesting—vesting is immediate.
Options—additional plans are permitted.
Automatic enrollment can boost participation, enabling employers to take advantage of more tax breaks.
Plan Pros and Cons
IRA-based plans, especially payroll deduction IRAs, benefit from no filing requirements and are relatively easy to set up and administer. Defined contribution 401(k) plans typically have greater administrative and filing requirements. However, 401(k) plans offer special tax benefits by deferring taxes on employee contributions and gains on investments until distribution. This deferral can mean the employee owes less taxes if they are in a lower tax bracket after retirement. This deferral can make a significant difference for a self-employed individual choosing between a solo 401(k) vs. a SEP-IRA.
All plans also offer tax advantages through contribution deductions. Some plans offer more than others based on flexibility in how much the employer contributes. Specifically, employers may deduct more if they contribute more, so the tax benefits of a SEP-IRA can be greater than those from a SIMPLE IRA, for example. Defined benefit plans are less popular than they used to be, but the guaranteed benefits they offer tend to be popular with employees. Still, they include more filing and reporting requirements and impose administrative burdens that others do not.
Choosing a Plan
Your plan selection depends on your unique needs and what you want to offer. Each type of plan offers advantages and disadvantages, especially related to administrative requirements, flexibility, and tax incentives.
Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
Resources:
- IRS, 401(k) resource guide - Plan participants - Summary plan description, link.
- IRS, 401(k) resource guide - Plan sponsors - General distribution rules, link.
- IRS, Choosing a retirement plan: Money purchase plan, link.
- IRS, Choosing a retirement plan: SIMPLE 401(k) plan, link.
- IRS, Defined benefit plan, link.
- IRS, A guide to common qualified plan requirements, link.
- IRS, Individual retirement arrangements (IRAs), link.
- IRS, Payroll deduction IRA, link.
- IRS, Publication 560 (2023), Retirement Plans for Small Business, link.
- IRS, Retirement topics - 401(k) and profit-sharing plan contribution limits, link.
- IRS, Retirement topics - IRA contribution limits, link.
- IRS, SEP contribution limits (including grandfathered SARSEPs), link.
- IRS, SIMPLE IRA plan, link.
- IRS, Simplified Employee Pension plan (SEP), link.
- IRS & Employee Benefits Security Administration (EBSA), Choosing a Retirement Solution For Your Small Business, link.
